Do not Go Chasing Distribution Waterfalls: The Future of VC Compensation

Just recently I read Kanyi Maqubela’s post on distribution waterfalls and carried interest and felt compelled to write a rebuttal. First of all, there is no such thing as a European style waterfall – not anymore, at least. If anything, most American VC firms are the ones who use that supposedly “European” style waterfall, where the principal must be paid back before any carry is made. Since most LPA’s are bespoke agreements and highly individualized, a “European” or “American” style waterfall doesn’t really exist. During the dot-com boom, VCs were robber barons and had LPs on their knees with deal-by-deal carried interest, because times were pretty damn good. But when the party ended, LPs lost their collective shirts and implemented the safer distribution waterfall that we commonly now see today. Deal-by-deal carry is incredibly rare now and I doubt that many US or European VC firms are able to convince their LPs to agree to it. Instead, we are now seeing more distribution waterfalls that directly reward performance.

For example, carried interest that incrementally rises, based on return multiples (if the VC gets a 2.5x return on invested capital, the carry increases from 20% to 25% and so forth). But what I really want to expand upon is the future of VC compensation. Just recently, a new fund called Maiden Lane emerged from the brain trust over at Angel List. Maiden Lane’s approach is simple enough: a $200k check for select angels to invest in a company of their choosing and a 30 percent carry, with no management fees. It’s quite brilliant when you think about it: spread the money around to the best and brightest angels and let them invest in the next big startup. The implications of this new model are huge. Instead of LPs focusing on investing large chunks of capital in a small handful of funds, they can now leverage the talent and experience of multiple VCs. And the best part is: not having to pay those pesky management fees anymore.

I foresee a future where VCs and angels make individual capital calls to LPs. Found a new startup that you think will be hot? Pick up the phone or fire off an email to an LP requesting $250k. Rinse and repeat as needed. Now VCs and angels won’t have to go through the time consuming process of raising a multi-million dollar fund. There is also the possibility of a new class of angels/VCs that could be created. If LPs wrote smaller checks, they could try out new and emerging angels that have potential. A $250k bet on a new VC is certainly less risky than giving him $10 million for a new fund. And with the smaller amounts and no management fees, the VC is forced to source and invest only in the most promising startups. The competition landscape will also be drastically changed. Traditionally, VC firms competed against one another for LP funding. But if Maiden Lane’s new model proves to be successful, it could create a new wave of smaller VCs who will compete against the billion dollar funds. After all, why would an LP keep paying millions in fees for an under performing VC when they can get results from just a few quality angels?

If all of the above comes to pass, Sand Hill Road might be forced to rethink their compensation structures. Perhaps we will see one-time management fees where fees are only paid out in the first year or maybe the VC has to earn the rest by achieving milestones for the remainder of the funds life cycle. Another interesting scenario would be VCs and angels earning equity stakes not through investing startup capital, but through real value add. Since the JOBS act would allow Joe Investor to play VC, the new injection of capital could number in the billions. Startups won’t need to pitch VCs for funding anymore, because they can get it elsewhere. So instead of funding, VC’s could offer services in exchange for equity. Help scale my startup and I’ll give you 5% equity. Help me hire the best engineers and I will give you 2%.

VC’s of the future will no longer be merchants of startup capital but merchants of startup services instead. Could this spell the end of traditional Venture Capital as we know it? Could Fred Wilson’s prophecy of VC ceasing to exist in 25 years actually come true? If you ask me, the end has already begun. Although I agree with Fred that VCs themselves won’t disappear, their roles will change dramatically. But I, for one, welcome change. After all, we invest billions of dollars every year in change and innovation.